Tuesday, October 13, 2009

Financial Meltdown, Part II

”I have enough money to last me the rest of my life, unless I buy something.” (Jackie Mason)

Having discussed the build up to the boom in Part I, Part II will focus on its bursting and the challenges it brings.

One of my favourite pithy ways to summarise the past few years, is to emphasise that if the good times never ended, then they’d just be called the times.

The key assumption that asset prices could only rise, was prevalent throughout the boom.

If this were indeed true (and not merely in ‘good times’), then the rational course of action was to maximise asset accumulation, and not concern oneself with the servicing of the debt thereon.

This mad rush to borrow to purchase assets was observable not only at the individual level (think of the ‘buy to let’ phenomenon), but also the corporate level (eg. Lehman Brothers) and even the level of an entire sovereign nation.

Consider the amazing case of Iceland for example. For decades it enjoyed a peaceful and prosperous existence, thanks to its abundant fishing industry, natural geothermal power and its vital Cold War military location halfway between the US and Russia.

So what on earth persuaded the Icelandic people that what the world really needed from them was their banking prowess?

Nonetheless during the course of just a decade, its three major banks (Kaupthing, Landsbanki and Glitnir) managed to build up an asset base equivalent to more than eight times the size of the entire Icelandic economy.

As the Icelanders and many others are now finding out, much of the apparent prosperity of the last decade has been a chimera created by borrowed money. Even those that were sensible with money benefited indirectly, from the spending of those that were not.

Credit served its short-term purpose, offering a glimpse of prosperity that hasn’t been earned yet. However given that debt is merely consumption brought forward, borrowers must now retrench and those bills now have to be paid.

The economy has thus plunged into recession and when it slowly emerges and returns to a degree of normalcy, it will be less dynamic than before (more about this in Part III).

We have only avoided a 1930s style outright depression through the partial replacement of lost consumption with government spending.

Via a globally-coordinated plan, much of the debt overhang in the private sector (especially at the banks) has been replaced by debt at the public level.

This has been both explicit via outright nationalisation, and implicit via a myriad of complex asset guarantee schemes (some of which may hopefully never actually be required).

In addition governments around the world have embarked on stimulus packages, in order to act as a source of new exogenous demand to fill the black hole left by lower consumption.

The policies enacted so far can probably be described as one of the finest ‘deferrals’ of major problems in modern times. After all this extra government spending must eventually be paid for by higher taxes, higher debt interest or some form of money debasement (inflation).

This fiscal spending boost is temporary, but if it were channelled more towards infrastructure projects or education, then there would at least have been some long-term benefits to the younger generations upon whom the bulk of the debt burden will now fall.

Instead the government has tended to prefer short-term measures like the car scrappage scheme, effectively a handout with no discernible long-term benefit.

Allowing the irresponsible to fail, or investing public money in long-term projects whose benefits may not be seen immediately, is politically unpalatable it seems.

Why was taxpayer money spent for example on repaying UK depositors in those Icelandic banks, despite the warning signs? Where instead is the refund on interest foregone for those savers who sensibly deposited money in more staid institutions? This is ‘moral hazard’ gone mad.

However for the timebeing the presence of an overbearing government in the economy, has been described as being akin to having a “..bear in a canoe..” You’d rather he wasn’t in there with you but if he jumps out now, the canoe will capsize.

Government debt in the UK is projected by the Treasury to peak at 80% of GDP. If the average interest rate on this debt is just 4%, merely servicing this debt will cost the government as much as the combined 2009 budget for education and defence alone.

In a recognition of tough times ahead, it is already clear that the forthcoming UK General Election will have austerity measures at the very heart of campaigns.

I will discuss the implications of the sudden increase in government indebtedness in Part III, but I find it somewhat comforting that this issue is already being debated so publicly.

At least whilst the politicians may be both greedy and stupid, it seems they are reassuringly not mad too, collectively recognising that we must take some considerable pain now to avoid even worse calamity later.

Structural long-term unemployment is likely to remain uncomfortably high though, with all of the social problems it brings.

Just as the benefits of the boom were not evenly distributed, neither will be the costs of its unravelling. The large (but so far irrelevant) boost in support for the BNP can be seen in this context.

For unemployment to fall materially, it requires real GDP growth to exceed the rate of productivity growth plus the rate of growth of the population available for work.

Yet it is now clear that much of the economic boom of the past decade (in which job creation was strong) was driven by a credit machine that is now broken.

It is thus difficult to see how unemployment can fall because rates of economic growth will not be high enough to let it happen.

The media meanwhile has clearly charged bankers with causing the meltdown, but this is at best simplistic, and at worst plain wrong.

If house prices are oddly the ultimate gauge of the public’s optimism, then few were complaining when the wild credit expansion of those very banks directly caused them to rise.

A cynic might argue therefore that it wasn’t what the banks were actually doing that was so upsetting to the public, but the fact that they eventually blew up (which isn’t quite the same thing).

As I discussed in Part I, bankers were merely acting rationally as regulators and politicians turned a blind eye, surfing on the wave of popularity that their fake boom was creating.

Indeed I’ve often thought that a benevolent dictatorship might be more suitable than a democracy for managing the greed and fear of an economic cycle, capable of making difficult decisions without fear of electoral consequences.

Shareholders were complicit too, many of them overseeing the pension funds of those very members of the general public now feeling so angry at the course of events.

The share prices of banks were awarded the type of valuation multiples typically reserved for true growth companies, yet surely in sum the banks can only grow at the same rate as the economies they service?

Bonuses are seemingly abhorrent to the public, but it is the way they were paid rather than their very existence which represented the true menace, despite the headline-grabbing rhetoric. This issue is now being addressed by the Labour government, just a few years too late.

Just like other highly-paid industries like football, the banking industry is blessed with massive ‘economies of scale’.

Wayne Rooney does not need to try any harder whether Manchester United’s game is being beamed to 50 million people, or to 500 million people, but the rewards to his club (and indirectly to him) are considerably higher.

The revenues and costs of banks also do not move in a linear fashion. The diligence required to syndicate a £500million loan for example is not ten times the work required for a £50million loan, but the fees earned will be commensurately greater.

These scale effects as well as the ongoing trend towards globalisation, ensure barriers to entry in banking are large and thus the industry is dominated by just a dozen or so behemoths, each hugely profitable and with the ability to pay handsome bonuses.

The fact that likewise both domestic and European football is dominated by a similarly small number of clubs is not coincidental in my view.

However large football clubs can project forward and estimate their revenues within a far narrower realistic range than banks can.

Season ticket sales are paid in advance, whilst full stadia at top clubs are largely a given. Some key commercial deals like shirt sponsorship are often fixed for years in advance.

Meanwhile unlike in banking, players are locked into contracts of varying length, so the ‘carrot’ of future bonuses is not required to encourage loyalty specifically.

Thus the pay of footballers is disproportionately received in the form of salary rather than bonuses (although these still play a role here too as a variable cost buffer).

The real problem came when many of these banks grew so large that they were considered ‘too big to fail’, and governments across the world were forced to step in to protect depositors and bondholders, and to restore trust.

They were not similarly disposed towards distraught fans of the likes of Leeds United or Fiorentina it should be noted, and this is where the analogy with football effectively breaks down.

By privatising reward but socialising risk in this way, governments effectively wrote the banks a free option to take outsized bets.

Once again, they acted rationally and took that free option, but not in a sinister way in my view. Every pound lent was a pound borrowed after all.

The horse has now bolted, but new regulations will ensure that a greater proportion of bonuses are deferred, and thus capable of being clawed back if unrealised profits turn back to loss.

Due to the above economies of scale however, the banking industry is inherently predisposed to create giant entities. Properly regulated like utilities, size should confer benefits upon clients and consumers, and not merely the bankers themselves.

If banks must by definition end up ‘big’, then we must also ensure they cannot ‘fail’, or at least be capable of dealing with failure without recourse to the taxpayer.

New regulations on capital requirements, liquidity and so-called ‘living wills’ seek to address this issue but regulators are like generals, always fighting the last war. The next crisis will doubtless look different.

In the meantime however, given that the taxpayer now owns large chunks of the banking system, it is important to encourage smart people to work there.

The systemic risk may have been neutralised, but the balance sheet of RBS alone remains larger than the entire UK economy. It can’t just be left to fester as its best people depart in droves, terrified of a populist backlash.

After all, the first wave of banking problems as discussed at length in Part I was the result of the boom in securitisation, and lending done ‘off balance sheet’.

The second wave that may engulf the system involves the precarious assets that sit ‘on balance sheet’, the traditional commercial and consumer loans upon which defaults will continue to rise as economic growth remains tepid. The banking crisis is not over and considerable new capital is still required.

Thus as unpalatable as it sounds, the solution to the ‘bonus problem’ may indeed be more bonuses if the banks are permitted to gradually earn their way back to health, and thus replenish their battered capital base.

The sooner they become profitable again, they sooner they can be returned to private hands and cease to be a further fiscal burden.

But now that the banks are safe from collapse at least for now, government and media demands that they increase lending are falling on understandable deaf ears.

This is not a traditional recession, namely one typically brought about by an increase in interest rates, in order to take the heat out of a booming economy. Instead this is a recession occurring with global interest rates already effectively at zero.

Rather than interest rates merely squeezing some life out of an overly expansionary (but otherwise healthy) economy, we are instead witnessing a classic debt-deflationary bust.

Defaults and subsequent losses (because debts could no longer be serviced), lead to forced asset sales and repossessions, leading to further defaults and losses.

Japan has been in a debt deflation cycle for two decades, which may strangely be viewed positively given that there has been no discernible fall in living standards there during the entire period. For several reasons however, it does not serve as a useful precedent.

Firstly it has always been a nation of savers, so its enormous government debt spending could easily be financed domestically, whilst for others those high savings acted as a fallback option to maintain spending.

Second, until recently of course, its deflation occurred concurrently with a boom in the rest of the world, providing huge demand for her famous exports, helping to boost growth.

Third its money printing was not inflationary because with its own interest rates near zero, yet with much higher rates available elsewhere, the printed Yen was generally sold in exchange for foreign assets. Today all major interest rates are effectively at zero.

Fourth, it may finally be reaching its denouement anyhow, as its demographic timebomb threatens to explode.

The country already has more citizens outside the workforce than in it, and given its famously low immigration rate, its debt issuance may finally be reaching a ‘tipping point’ where it can no longer be funded without a sharp rise in interest rates and a currency collapse.

Back in the West, since credit should sensibly be extended following an assessment of net worth (wealth) and incomes/cashflows, then since both have fallen then inevitably credit creation is greatly constrained.

The key to a new healthy credit system (in which both borrowers and lenders enter into transactions freely and without interference), rests upon the concept of viability.

The system will be viable again when providers of credit are willing to lend it, in exchange for believable claims that it will be returned with interest. The banks insistence for example upon 40% deposits for home purchases should be seen in this context.

The current government programs do not address this viability problem, focusing instead on restructuring and guaranteeing legacy loans that should never have been created, and will never be viable.

Eventually the government’s own borrowing will need to pass the ‘viability’ test in the eyes of foreign lenders too, but that’s an issue for Part III.

Meanwhile on the demand side for credit, the cohort of borrowers willing and able to enter a viable new loan at this stage of the cycle, is greatly diminished.

Indebted companies and consumers are instead furiously seeking to deleverage, whilst the cash-rich generally consider it too early to lever up again.

Thus in the absence of enough attractive viable risky loans to extend, banks are again acting rationally.

They are choosing to rebuild their depleted capital bases and using their near-zero cost of capital (think of deposit rates), to lend only to the safest borrowers including the government itself. As mentioned above, there’s certainly no shortage of issuance.

I will dwell more upon this understandable absence of speculative ‘animal spirits’ in Part III, particularly with regard to the inevitable inflationary consequences for when it returns.

Throughout history, all episodes of money-printing lead to a short-term ‘feel good’ factor. After all inflation is tomorrow’s story, as those aforementioned deflationary forces of rising unemployment and debt payback greatly overwhelm it for now.

The ‘feel good’ factor derives from the public’s focus on the extra money in their pocket, not on its rapidly falling purchasing power.

But in a so-called ‘fiat money’ system where money is no longer backed by gold, a currency only has a relative value in terms of goods and services it can be exchanged for. It has no intrinsic value, and is thus capable of manipulation.

As a result, whilst for example a dollar bill states ’In God We Trust’, it seems many investors prefer to believe that ’In Gold We Trust’, pushing the price of the yellow metal to new highs.

By way of an interesting anecdote, if gold is indeed the only true ‘store of value’ then consider this for example. During the ten years ended September 2009, the average UK house price (according to Nationwide) rose 121%.

However ten years ago that average house would have cost you 419 ounces of gold, and right now it would only cost you 257 ounces of gold, implying a 39% drop!

No wonder UK politicians on all sides are so enthused by this neat trick, and indeed the flexibility of the pound has provided a temporary boost, but what is the end game for this game of currency debasement?

After all by definition all countries cannot depreciate their currencies at the same time, yet virtually all would like to.

The answer lies surely in a belated rebalancing of the world economy, towards greater consumption in the traditional saver nations (eg. China), and greater saving in the traditional consumption nations (eg. US, UK).

Standards of living in the former would rise at the expense of the latter, but permit the gradual debt restructuring required, eventually boosting domestic jobs through the effect of the weaker currency.

It sounds neat but the political and social ramifications are large, with China particularly reluctant to disturb the country’s swift urbanisation on the back of cheap exports.

Cooperation and mutual understanding is key, not least because the surplus countries hold so much of their enormous reserves in the currencies of debtor nations. They are understandably reluctant to cut off their nose to spite their face.

In the words of the G20 last month in Pittsburgh: ”We will need to work together as we manage the transition to a more balanced pattern of global growth.” In Part III, I’ll discuss how successful they’re likely to be, and the risks therein.


At 6:54 AM, Anonymous Anonymous said...

Yeah, yeah, yeah.

But should we only play 442 when all else fails.

Valley Mick

At 8:51 AM, Blogger Suze said...

Some understand, some don't...others don't care and others don't want to know the global ramifications of your points, or how we collectively made our way to the situation each country now finds itself in... Even though it's well written, argued and expertly put.

They see the bonuses of those bankers as an anathema, coupled with the expenses scandal, helped by media doggedness at the "expose", as corruption at worst, greed at best.

Being urged to save with a barely non existent interest rate has very little incentive. Seeing the price of a loaf rising along with other commodities and utilities, and being told (even if you're not selling) your largest asset has lost value, aren't things that endear most to those who do gather the bonuses and expenses, even if deserved.

We are now entering a series of votes to strike...even if they've not already started. The public sector has been told it will suffer. Couple this with the cutbacks and/or selling of assets (depending on who wins the next general election), and the pension age being pushed back. I think there'll be some bloody finger nails before we get through this...those clinging on and those scrambling to find a way out.

And...we change formation when the need arises...whenever that may be.

At 9:06 AM, Blogger Wyn Grant said...

Cooperation and mutual understanding is no doubt key, but how you acheive it is another matter given divergent interests. Having said that, G-20 has worked better than I thought it would, while the IMF has enjoyed something of a revival.

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